What Business Owners Should Know About Commercial Leases - VR Business Sales Blog

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Monday, June 29, 2020

What Business Owners Should Know About Commercial Leases

Most business buyers are first time buyers, and there’s a lot to learn about running a business. The fundamental rule of business is to make more than you spend, and the largest fixed cost of many businesses is often the rent. Most first time buyers have never had a commercial lease either, so there’s more to learn here…

Today we’ll explore some important aspects of a commercial lease, and how it could affect both the buyer and the seller of the business.

Fixed vs Percentage Leases

You might think your lease will be the same every month, and this is the case with most leases. This is called a gross lease, the price is fixed. But some landlords want a piece of the action; they may ask for a percentage of your sales. In most arrangements of percentage leases there will be a base rent, with additional rent due for a percentage of sales over a specified amount.

Here the landlord will be asking for your monthly financials to determine how much you owe them. In most cases, it’s easier for planning purposes to know what your fixed costs will be with a gross lease, but some owners prefer a percentage lease so they can limit their fixed costs and the rent can act like a variable cost similar to payroll or COGs.

It may go without saying, but as a rent payer, you want to ensure that your rent is as low as possible, and if a percentage exists, ideally you want it to be high enough so you never pay that additional rent. Even if you're comfortable with the cap at which you have to pay additional rent, this could deter buyers of your business who plan to increase sales in your space.

Escalations

Another aspect of rents that may go without saying is that the rent almost always goes up. In the NC commercial real estate market, a 3% escalation has not been uncommon. While this may change in the COVID Era, landlords have gotten away with a 3% annual escalation in rent for a long time.

Like many things in life, almost everything is negotiable. Here a business buyer could negotiate if they’d rather have a consistent rent for a longer period, but the landlord may counter that the rent may escalate to a higher level to balance out. Depending on the buyer’s goals this could be beneficial. The important thing to know is that landlords are prepared to negotiate on terms like the escalation percentage.

Term and Options

Rents also come with a length of time you can use the space, and that term is often 3-5 years, but sometimes it can be 10 or more. Here the business owner is gambling on the future. If the owner has a great rent and they believe in their success in the future, and they want to secure that rent for a long time. On the other hand, an owner may want a shorter term, but have the opportunity to extend the lease with options.

Some landlords don’t like to give options, but they can be great for both the tenant and the landlord. Essentially, an option says “let’s decide when we get closer to the time to extend if we’re happy with the situation.” A good term with options can give an owner the chance to keep doing business in the same space, but also have the option to stop being obligated to the space at each option to renew.

Some owners don’t like to negotiate for the long term, because they want the chance to renegotiate every few years, in the event that the market favors the tenant and they believe they will have the opportunity to get a better deal on the rent. In down markets, when the tenant sees that many of their neighbors' storefronts are empty, a successful tenant may feel that he or she can negotiate a lower rent.

CAMs

Oftentimes there’s more than just the rent. Sometimes new tenants see that rent comes with CAMs and business buyers have assumed it meant that there were extra charges for security cameras. This is not what CAMs are.

CAMs are Common Area Maintenance charges. A rent may be $5,000/month, plus an additional $1,000 for CAMs. Those charges may cover the tenant’s portion of the shopping center for services the landlord provides such as repaving the parking lot, electricity for the common areas, and more. When the tenant’s portion of the shopping center’s real estate Taxes and Insurance for the property are added, it’s sometimes called TICAM.

Where the base rent is predictable and agreed to over the long term, the CAMs may fluctuate on an monthly or yearly basis, and are often reconciled when all the bills come in at the end of the year. When doing a business deal and assuming a lease, be sure to ask if CAMs have been reconciled yet to avoid paying an unfair share of the former tenant’s bill.

Assignments Vs. New Leases

If you’re taking over a space from a previous owner, you may either be assigned an original lease, or you may be getting a new lease. It depends on where the former tenant was in their lease. A savvy business owner will have their space protected for a long time into the future, so the lease will need to be assigned, but some owners let their lease run out and it may be time for a new lease.

Landlords tend to prefer to assign the previous terms of an old lease because it’s less legal work for them, but sometimes if it’s towards the end of a term they may elect to just start a new lease with new terms.

If you are taking over another owner’s lease, be sure that you have the full lease, and not just the most recent amendment to the original lease. It’s important to know that you’re agreeing to the original lease, and the assignment and any amendments refer back to that document; unless you are agreeing to a wholly new lease.

The Personal Guarantee

The Personal Guarantee, or PG, is one of the largest challenges that departing business owners face. Landlords will typically have a tenant sign a lease by their corporation and then personally guarantee the lease. This means that if the owner closes the business, the individual owner is still on the hook for lease payments for the full term of the lease.

The challenge with assignments is that even though landlords “cannot unreasonably withhold” a lease from being assigned to a new tenant, they don’t have to release the original tenant from the personal guarantee, and commonly they will not. This is often the de facto position of the landlord. Sometimes called “two throats to choke,” the landlord’s position is that holding the PG is what gives them comfort in assigning the lease to the new business owner.

It can be uncomfortable for a business seller, but the good news is that in order for the lease obligation to come back to the original owner, the landlord would have to have a default by the business buyer/new tenant, and they may be able to find a replacement tenant to take over the obligations. The landlord doesn’t want to come after a former tenant, and they don’t want an empty space that’s not open and operational; it lowers the value of their space.

For business owners who are planning ahead, negotiating to remove the personal guarantee is a wise move when renegotiating a lease for an extension. At this stage, the landlord trusts the business can pay the rent because they are renewing, and the tenant is in a position to ask for favorable terms because they currently have the option to move the business.

The Takeaway

Let’s face it, commercial leases can be intimidating, long, and boring to read. But they’re important documents and can make the difference in a successful, transferable business, and a business that only makes enough to pay the rent.

Savvy business owners protect their space with long term leases, they understand the fixed and variable costs, and they protect themselves with options and opportunities to renegotiate. With a little luck and a lot of planning, an owner can position a business with a strong, transferable lease that adds value to the business for the next owner, and with minimal exposure.

If you have questions about your commercial lease in relation to the value of your business, contact Neal Isaacs, MBA, CBI at VR Business Broker at VRbizTriangle.com

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